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Mutual Funds and Mutual Fund Investing - Fidelity Investments

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Fixed income is generally considered to be a more conservative investment than stocks; however, investors should still be aware of the potential risks that bonds and other fixed income investments may carry.

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The yield curve is one of the most important tools to gauge investor sentiment regarding interest rates. If you understand how to interpret a yield curve, it may even be used to help gauge the direction of the economy.

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The "Introduction to fixed income" course explained the differences between bonds and bond funds. Now let's dig a little deeper and discuss the importance of knowing the tax implications of both.

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In this lesson we discuss the importance of being diversified across maturity dates when investing in individual bonds. Bond ladders, barbells and bullets are three strategies that may help you achieve this.

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Pay special attention to the section on liquidity risk. Too often investors underestimate the impact liquidity can have on an investment, particularly when markets are volatile.

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Mortgage-backed securities typically offer yields that are higher than government bonds. Securities with higher coupons offer the potential for greater returns but carry increased credit and prepayment risk, meaning the realized yield could be lower than initially expected.

What are Fixed Rate Capital Securities (FRCS)?

Fixed Rate Capital Securities (FRCS) are hybrid securities that combine the features of both corporate bonds and preferred stock. Typical issuers of FRCS include utility companies and financial institutions.

Fixed Rate Capital Securities generally have higher yields than preferred stock and corporate bonds of the same issuer to compensate investors for increased risks. These risks stem from the fact that FRCS rank lower in the corporation’s capital structure than senior debt, and because the issuing corporation can defer interest payments. Income from FRCS is usually distributed on a monthly, quarterly or semiannual basis and is fully taxable. The securities themselves can be structured as either equity or debt; you’ll have to read the prospectus to determine the structure of a particular FRCS. They generally have stated, and long-dated, maturities, usually from 20 to 49 years, although some are “perpetual”, which means that there is no fixed maturity date.

Features and Benefits

Priority of claims: In the event the issuer runs into serious financial trouble, FRCS typically offer a higher security claim than preferred and common stock, but rank junior and are subordinate in right of payment to all senior debt of the issuer.

Potential for attractive yields: FRCS typically provide higher yields than preferred stock and corporate bonds of the same issuer, partly to compensate investors for claims with a lower priority in addition to payment deferral risk.

Liquidity: FRCS can be purchased as new issues and also bought and sold on the secondary market, like stocks and bonds. Many FRCS are listed on the NYSE®, while others trade over the counter (OTC). All generally have easily attainable quotes.

Credit ratings: FRCS are generally rated by investment rating agencies such as Moody's® and Standard & Poor's® to assist investors in their evaluations of the securities.

Low investment minimum: Many FRCS are issued at $25 a share (although some are issued with a $1000 par value). This feature enables investors to buy and sell in smaller increments. The actual price paid by the investor may be more or less than $25, particularly when the security is purchased in the secondary market.

Risks

Market risk. FRCS are subject to price fluctuation due to events affecting the issuer or the market. Additionally, FRCS prices typically decline on ex-dividend days—the dates that buyers of FRCS are not entitled to receive the dividend.

Credit and default risk. Investors face the same risk of default as they would with a corporate bond—the company could become unable to pay investors interest or repay principal. FRCS are deeply subordinated, however, so actual recovery rates in the event of default may be much lower than senior securities. Purchasing top-rated securities from companies with a stable or good credit history may help reduce credit risk.

Call risk. FRCS generally have a call provision that entitles the issuer to redeem the shares prior to maturity, returning the principal to the investor but eliminating the option of continued income from the FRCS. Typically an issuing corporation will call its securities when interest rates fall, which means the investor will likely face less favorable reinvestment possibilities. When evaluating FRCS, an investor should know whether call options exist and when these options may be exercised by the issuer.

Maturity extension risk. Although most FRCS have long maturities to begin with, many come with an option for the issuer to further extend the maturity date. Although this extension is generally limited to a maximum of 49 years, that may be beyond what many retail investors want.

Special event risk. The income paid to investors is tax-deductible to the issuer of the FRCS. If a change in tax law lessens or eliminates the corporation’s tax advantage, the company could execute a "special event" redemption option. This allows the issuer to redeem the securities at the liquidation value in the event of an unfavorable tax change.

Deferral risk. Companies issuing FRCS are allowed to defer income payments without declaring default if the issuer experiences financial difficulties. Payments may be deferred or suspended for a stipulated period. The deferred income may accrue during the period of suspension and could be paid later, but this could pose some tax issues for the investor. In the case of non-cumulative FRCS, deferred payments do not accumulate, and the issuer is under no obligation to pay the missed payments in the future. Read the original prospectus to understand the structure of their FRCS investment.

Inflation risk. Like bonds, investors in FRCS are subject to the risk that the yield paid from time of purchase to the time the FRCS matures or is called may not pay more than the rate of inflation in the same period. Even if the FRCS return does exceed the rate of inflation, inflation can reduce the value or purchasing power of the income received.

Liquidity risk. Although owners of FRCS should find it possible to find a buyer under most market conditions, it is nonetheless a fairly illiquid market with the risk of variations from anticipated valuations, particularly when interest rates rise or markets are volatile.

Types of FRCS

The current market includes three broad categories or structures of FRCS. The structures differ primarily as a result of whether the parent company issues the securities directly or through a conduit financing vehicle.

Junior subordinated debentures are issued directly by the parent company

Trust preferred securities are issued by a grantor trust established by the parent company

Partnership preferred securities are issued by a limited partnership or limited liability company organized by the parent company

To understand fully the implications of these different structures as well as the additional varieties of structures that affect the expected cash flows as listed in the “Risks” section above, prospective investors are advised to read the prospectus that accompanies a specific FRCS at the time of issuance.

Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "